ETF Insights.

​All sorts of possible cures have been suggested for the ills of active fund management. Cutting fees is surely the most obvious solution if the industry wants to stem the flow of assets out of actively managed funds. Simply trading less frequently would probably make a difference too.

One of the arguments we frequently hear is that the answer lies in higher conviction, or “real” active management.

It’s certainly true that the widespread practice of closet index tracking — charging active fees for effectively hugging the benchmark — is a big problem for the industry. As well as being fundamentally dishonest, it almost guarantees that, after costs, the investor will underperform a comparable index fund.

“Real” active managers, on the other hand, genuinely try to beat the market by investing in a smaller number of stocks which they believe will outperform.

Over the long term, only a tiny proportion of active managers outperform the market on a cost- and risk-adjusted basis — David Blake from Cass Business School puts the figure at around 1%. One thing those very few winners have in common, the evidence shows, is that they tend to be high-conviction managers with relatively concentrated portfolios. Understandably, then, the high-conviction approach is being heralded by some as the answer to the overwhelming failure of active managers to outperform.

But is it? For a start, a manager can can have high conviction and yet be completely wrong. Deviating from the index doesn’t mean you’ll see better returns than the market; it means you can expect different returns, which could either be better or worse.

New research by Tim Edwards and Craig Lazzara at S&P Dow Jones Indices suggests that far from solving active management’s problems, moving towards portfolios with fewer holdings may well exacerbate them. In a paper entitled Fooled by Conviction, Edwards and Lazzara suggest four likely consequences of active portfolios becoming substantially more concentrated, none of which makes comfortable reading for active investors.

Likely Consequence No. 1: Volatility will probably increase

Portfolios with a large number of holdings are less volatile than those with small number of holdings. So, for instance, if a manager reduces the number of stocks they hold from 100 to 20, the portfolio’s volatility will almost certainly increase.

Likely Consequence No. 2: Manager skill will be harder to identify

It’s already extremely hard to distinguish luck from skill in active management. Think of each stock pick as an opportunity for a manager to demonstrate their skill. The fewer stocks they pick, the bigger the impact that luck is likely to have on the outcome.

Likely Consequence No. 3: Trading costs will rise

There are two reasons, Edwards and Lazzara argue, why costs would probably rise with greater concentration. First, fund turnover would increase. Secondly, transaction costs per trade would also rise, because trading a higher percentage of the outstanding float in a security typically incurs a greater percentage cost.

Likely Consequence No. 4: The probability of underperformance will increase

Stock returns, in technical parlance, are naturally skewed to the right; in other words, the average stock tends to outperform the median. After all, a stock can only go down by 100%, but it can appreciate by more than that. Logically, then, portfolios containing fewer stocks will tend to underperform those with more stocks, because larger portfolios are more likely to include some of the relatively small number of stocks that elevate the average return.

Conclusion​So, what can we conclude from the Edwards and Lazzara paper? As the authors note, skilful managers sometimes underperform, and those who lack skill will sometimes outperform.

“The challenge for an asset owner,” they conclude, “is to distinguish genuine skill from good luck. The challenge for a manager with genuine skill is to demonstrate that skill to his clients. The challenge for a manager without genuine skill is to obscure his inadequacy. Concentrated portfolios will make the first two tasks harder and the third easier.”

Remember, S&P Dow Jones Indices is not a disinterested party in the debate about the rival merits of active and passive investing. It makes its money from licensing its indices for fund managers to use, and therefore has a vested interest in promoting passive strategies.

That said, this latest paper is a valuable contribution to the discussion and one which gives advocates of higher concentration in particular plenty to think about.

​What, one wonders, would Alfred Cowles III have made of the current “debate” about active and passive investing?

Cowles was born in 1891, the son of one of the founders of the Chicago Tribune. He became a successful businessman, but his true passions were economics and statistics. One question in particular exercised his mind — can the professionals predict the stock market? — and in 1927 he set out to find the answer.

Over a period of four-and-a-half years, Cowles collected information on the equity investments made by the big financial institutions of the day as well as on the recommendations of market forecasters in the media. There were no index funds at the time, but he compared the performance of both the professionals and the forecasters with the returns delivered by the Dow Jones Industrial Average.

His findings were published in 1933 in the journal Econometrica, in a paper entitled Can Stock Market Forecasters Forecast? The financial institutions, he found, produced returns that were 1.20% a year worse than the DJIA; the media forecasters trailed the index by a massive 4% a year.

“A review of these tests,” he concluded, “indicates that the most successful records are little, if any, better than what might be expected to result from pure chance.”

11 years later, in 1944, Cowles published a larger study, based on nearly 7,000 market forecasts over a period of more than 15 years years. In it he concluded once again that there was no evidence to support the ability of professional forecasters to predict future market movements.

What is so extraordinary about Alfred Cowles’ work, and the techniques he used, is how ahead of his time he was. Cowles was the first person to measure the performance of market forecasters empirically.

Even among students of academic finance, the common perception is that it wasn’t until the mid-1970s that the value of active money management was seriously called into question, most famously by Paul Samuelson and Charles Ellis. In fact it was Cowles, more than 30 years previously, who first provided data to show that it was, to use Ellis’ phrase, a loser’s game.

So why wasn’t Cowles’ research more widely known about? Why did it take until 1975 for the first retail index fund to be launched? And why is active management still the dominant mode of investing even now, in 2018?

There are probably many reasons. The power of the industry lobby and the large advertising budgets at the disposal of the major fund houses have undoubtedly played a part, as has the growth of the financial media.

But it was Alfred Cowles himself who put his finger on arguably the biggest factor behind the enduring appeal of active management. Late in life, Cowles was interviewed about his research into market forecasters. In Peter Bernstein’s 1992 book, Capital Ideas: The Improbable Origins of Wall Street, he is quoted as saying this:

“Even if I did my negative surveys every five years, or others continued them when I’m gone, it wouldn’t matter. People are still going to subscribe to these services. They want to believe that somebody really knows. A world in which nobody really knows can be frightening.”

Cowles’ prediction has proved to be spot on. Both active management and market forecasting are far bigger industries than they were when he died in 1984. Investors, it seems, still want to believe that the market can be beaten, despite all the evidence that no more fund managers succeed in doing it than is consistent with random chance.